Archives for October 2015

Global carbon prices should double by 2020 to around US$20, triple by 2030 to $30 and potentially sextuple to $60 per tonne by 2030, according to market forecasts.

While traded carbon prices are expected to remain weak until 2020, they’re expected to rise rapidly to $30-50 by 2030 and climb further after that.Sources: World Bank, Synapse, Point Carbon, ICIS, US GAO

Price rises like this will have a dramatic effect on the global economy.

The signals they’ll send will dramatically affect energy markets, reducing investment in coal and natural gas and raising it for solar, wind and other low emission energy technologies.

If these forecasts prove correct, it implies carbon prices will rise by about 10% per year from now to 2030. But there will be bumps along the way.

For instance, global carbon markets are moribund at present, hamstrung by a surplus of permits in the benchmark European Union Emissions Trading System (EU ETS) that may last until 2020.

This is holding prices down around US$10 per tonne and could do so for the next four years under the market’s current rules, which can’t be revised until 2020. At that point, prices are forecast to suddenly leap from $10 to $20 per tonne, and then potentially double again by 2030, to $40 or higher.

Despite these problems, the world’s fledgling carbon markets — led by the EU — are achieving their aim: influencing long-term price expectations for carbon and energy investments based upon these expectations.

These expectations can be seen in the various ‘shadow’ (or hypothetical) or internal planning carbon prices that corporations now use in evaluating new investment. Therefore, while traded carbon prices remain low, future expectations of higher prices are now influencing investment behavior.

This demonstrates the growing role that evolving carbon markets are playing in solving climate change. Carbon markets like the EU’s are only a decade old. As their early structural kinks get fixed, their effectiveness will rise.

Among other things, the upward trend in carbon prices they’re now signalling will steer huge pools of investment capital away from carbon intensive industries (like coal) and into lower emission energy like solar, wind, geothermal, biomass and others.

In 2015, the money changing hands through market-based carbon pricing schemes rose by nearly one-third to $22 billion compared $15 billion in 2014. But despite this growth, there’s still a long way to go. Only about 10% of global carbon emissions are now covered by some form of pricing.

Unfortunately, United Nations officials are tamping down hopes next month’s COP21 global climate change negotiations in Paris can agree to any global price for carbon.

That leaves — at least for now — the EU ETSas the pace-setter for global carbon pricing. Operating since 2005, the EU ETS accounts for roughly three-quarters of the global carbon pricing market.

A growing number of financial analysts now actively follow the market. Many of them provide forecasts on expected long-term price trends.

Each is now forecasting benchmark prices for future years, usually 2020 and 2030. Grenatec has taken these benchmark prices and ‘filled in’ prices for the years in between to create a inferred future price curve.

All the analysts expect EU ETS prices to hover around $10 per tonne until 2020 due to an oversupply of permits in the market. Unfortunately, these can’t be withdrawn until around 2020 under current market rules.

At that point, likely reforms may include either creating a ‘price floor’ below which prices can’t fall, or giving market administrators the power to withdraw permits from the market in periods of price weakness.

The aim of either reform, of course, would be to create an upward-sloping, multi-decade price expectation curve for carbon. That, in turn, would increase confidence for long-term investment in carbon saving technologies and infrastructure.

The good news in the market is that while actual prices may remain weak for several more years, long-term price expectations are shifting upwards, and this is what matters.

Both Synapse and Point Carbonforecast EU carbon prices will hit a Euro-denominated equivalent of US$20 in 2020, while price bull ISIS expects 2020 prices of $35 per tonne.

But even with this rapid growth, only the most bullish of the 2030 carbon price forecasts crosses over the US General Accounting Office’s (GAO’s) estimation of the US$50 ‘social price’ of carbon emissions in 2030.

This brave extrapolation represents the GAO’s best estimate of the ‘negative externality’ cost of burning carbon.

This ‘negative externality’ cost attempts to capture the negative impacts of unpriced carbon emissions on human health, the natural environment, government spending, weather disasters and reduced quality of life.

While the GAO doesn’t explicitly say so, the biggest ‘social cost’ to society from carbon emissions is almost certainly the roughly $5.3 trillion of implicit subsidies transferred from taxpayers to the global fossil fuels industry each year.

These subsidies encourage fossil fuel use by distorting the price system. This creates two huge problems simultaneously: climate change and higher tax burdens.

To limit the destructive effects of climate change and keep global warming below 2C between now and 2050, experts agree a combination of higher carbon prices and abolished fossil fuels subsides is needed.

At present, most future forecasts of carbon prices don’t see market carbon prices ‘crossing-over’ the GAO’s ‘social cost’ of carbon until 2030 at the earliest, when market traded carbon price estimates range from $35 and $50 per tonne.

Intriguingly, this $30-$50 price range is roughly in line with what many private corporations are penciling in for future investment using what’s known as a ‘shadow’ — or hypothetical — carbon price.

These now range from $10-$150 per tonne, with many large oil and gas exploration companies ranging from Exxon-Mobil to ConocoPhilips to Royal Dutch Shell penciling in mid-range prices of $40-80.

All of the above is relevant to China, India and Russia as they open their own carbon markets and their corporations develop their own ‘shadow prices’ for investment in new capacity.

What all of the above indicates is that while carbon markets are still undergoing painful teething problems, they are playing an important role in setting long-term carbon price expectations.

Therefore, the ‘big game’ is being won. It just may not look like it right now on the ground.

In addition to reducing fossil fuel subsidies and creating higher price expectations for carbon, the third big need in solving climate change is to expand carbon pricing beyond just the roughly 10% of global carbon emissions now covered by pricing schemes.

It will also open the way for various derivative (ie secondary) markets to develop to help take on or shed carbon price risk. These mechanism can include either market traded of over-the-counter derivatives such as puts, calls, swaps and traditional insurance.

They will also presumably lead to more transparent and liquid markets in trading energy, particularly across borders as countries with high emissions seek to import lower emission energy from more efficient producers.

All of this will attract growing pools of capital seeking reinvestment in lower carbon-emitting technologies. This will spur innovation, competition and technological advance.

This can be expected to lead to greater investment in cross-border energy delivery infrastructure such as high-capacity power lines and multi-fuel gas and liquid pipelines. These will reduce rigidities in markets that have given rise to long-term energy supply contracts to ensure security and continuity of supply.

This in turn will encourage creation of ‘spot’ markets, creating price signals for supply for immediate delivery – adding another important liquidity element to the spectrum of market trading. This is already occurring in Asia in the creation of Liquid Natural Gas ‘spot’ markets to supplement (and progressively replace) long-term LNG supply contracts at inflexible prices as wall as the inefficient legacy oil-indexed pricing of natural gas in Asia shipped as LNG.

The bottom line here is that while global carbon prices may be stuck in neutral until 2020 or so, deep underlying structural dynamics of new markets are being created through the refinement of future energy and carbon price expectations.

The good news is that all this should lead to less waste, greater competition, enhanced innovation and increased supply security — all of which will contribute mightily to solving climate change through applying the discipline of markets.

Advice: watch the carbon markets. We’re on the edge of a global economic restructuring around low emission energy that’s set to create the risk-taking visionary fortunes of the 21st Century.

As this occurs, secondary markets such as options, futures and over-the-counter risk-management derivatives can flourish given adequate liquidity in core carbon trading markets. This will further crystallize future price expectations, making future large scale infrastructure investment less risky.

Higher carbon prices could prove benign for the global economy. That is, if Germany and the UK offer any guide.

Germany and the UK are pushing ahead with higher domestic carbon prices for coal-fired power than in the rest of Europe. This is speeding up their economic transformation to lower-emission energy.

Both the UK and Germany are pushing domestic energy market restructuring now by creating their own higher carbon prices.

In the UK, this has been done through instituting a carbon ‘price floor’ of roughly US$30.

In Germany, it’s been done through requiring lignite-burning coal plants to buy additional European Union Emission Trading System (EU ETS) carbon permits.In both countries, the aimhas been to discourage coal-fired power and encourage a shift to cleaner, primarily renewable, energy.

Germany emits roughly 30% of the EU power sector’s greenhouse gas emissions covered by the EU’s ETS. The UK accounts for about 15%.

Both countries are committed to aggressive national greenhouse gas reductions: the UK of 35% fro 1990 levels by 2018-2022 and Germany by 40% from 1990 levels by 2020.

In both countries, applying higher domestic carbon prices for coal-fired power is shifting energy production toward cleaner energy.

In both countries, solar and wind energy is now cheaper than coal-fired electricity. In the second quarter of 2015 — for the first time — more electricity was generated in the UK from renewables than from coal.

In Germany, meanwhile, the production of renewable energy has risen while carbon emissions and wholesale prices have fallen.

If these trends continue, the UK may eliminate coal-fired power from its domestic energy production mix by 2023. In Germany, dirty lignite power plants may all be forced offline as early as 2021.

Emboldened by this, both countries want to see market reforms enacted to the EU ETS to drive carbon prices higher — ideally to around 20 Euros (roughly US$22) — by 2020 and higher thereafter. At present, surplus permits dog the EU ETS. This has caused carbon prices to fall and stay below 10 Euro (roughly US$11).

Administrators are now negotiating reforms to the market with a implementation target date of 2020. Two reforms could be applied.

The first would be a a ‘price floor’ (say 20 Euros). Below that level,a carbon tax would be applied, putting a lower limit on prices.Another method would be to allow market managers to withdraw permits from the market when prices fall too low (as they have now).

Either change would work. Or both could be applied.

For its part, the UK already has instituted a domestic carbon price floor of 23 UK pounds, or about US$30.

This is achieved through imposing a fluctuating domestic carbon tax on top of participation in the EU ETS. Under the UK scheme, the domestic carbon tax fluctuates inverselyto EU ETS prices.

This creates certainty about UK domestic carbon prices regardless of what occurs with prices in the EU ETS. The only unknown variable is the amount of carbon tax revenue the UK government gets. Business, however, gains future price certainty. This increases confidence for future investment.

What’s novel in the UK and Germany is how they have applied domestic carbon policies as a supplement to participation in the EU ETS. These allow both countries to configure domestic policies to optimize the benefits.

For instance, the UK has good wind resources its long coastline on the North Sea. Higher, predictable domestic carbon prices encourage building wind farms to replace coal.

While this raises domestic energy prices, it also encourages the growth of a wind industry, a long-term national asset. One side effect, however, is that UK power prices are now higher than those in mainland Europe. But these are partially offset by the anticipated lower future health costs caused by coal burning.

In Germany, meanwhile, the situation is a bit different. While Germany has wind resources in its portion of the North Sea, these aren’t as extensive as in the UK. Germany’s problem, by contrast, is its VERY dirty lignite coal industry.

As a result, Germany now requires her dirtiest lignite-burning coal-fired power plants to buy extra EU ETS carbon allowances from 2017. This effectively raises the cost of lignite-powered electricity.

The benefts are two fold. It creates a market incentive in Germany to close down its dirtiest plants. But it also helps soak up excess carbon permits now keeping prices weak in the EU ETS.

And all this indicates markets can work when properly designed. This can take time. While the process of finding the right policy mix hasn’tbeen flawless to date in either the UK or Germany country, the positive results look increasingly clear.

This has great implications for other carbon markets, most notably in China and North America. China plans to being a nation-wide ETS in 2017 based upon extending the reach of several urban and regional pilot markets now operating on an experimental basis.

In North America the two major carbon markets — the Western Climate Initiative (WCI) of some US western states and some Canadian provinces and the Regional Greenhouse Gas Initiative (RGGI) of US northeastern states are likely to progressively integrate over time.

As they do, both can learn from the flexible, experimental and apparently successful efforts of the UK and Germany to complement localized, domestic carbon policies alongside participation in larger, regional markets.

By fits and starts, the world’s moving toward a credible carbon pricing mechanism. This process pick up speed as the years go on.

These are the world’s three biggest homework assignments between now and 2020 in tackling climate change.

All can be achieved through domestic policy tweaks, international peer pressure and tougher administrative rules. All look achievable.

The most urgent need is to reform carbon markets to ensure carbon prices rise over time. This problem is most dramatically on display in the European Union’s Emissions Trading Scheme (EU ETS). .

The market opened in 2005. In 2006, prices reached a high of around US $36. Since then, they’ve crashed, and now languish below US$10. What happened?

When the EU ETS was created, the idea was that fewer permits (or ‘licenses’ to emit carbon) would be issued over time. This would push prices higher and lower carbon emissions.

But in 2008, the global financial crisis caused a big downturn in economic activity. This reduced carbon emissions (which was good) and therefore demand for carbon permits (which was bad).

Carbon prices fell to around $11 in 2008, rebounded to about $18 in 2011, and then headed south, hitting a low of about $4.50 in early 2013.

They’re currently stuck around $10. Short-term pessimism reigns.

Sadly, this flaw in the EU ETS can’t be significantly changed until around 2020. This means EU carbon prices may stall low until then.

The good news is that this really may not matter that much. The reason: while traded prices may remain low for another five years, future price expectations are rising. It’s these expectations that matter. These govern investment.

Looking forward, market analysts believe EU ETS carbon prices will rise to around US$22 in 2020 and rise to $33 and above after 2030. It’s this price that matters. And that’s influencing expectations.

In other words, while the actual market isn’t functioning well, the expectations it’s creating about future carbon prices is working. And it’s this that matters.

These expectations are largely due to the credibility of likely reforms to the EU ETS in 2020. These are likely to take one of two forms — either of which, or both — should fix the market.

The first reform would be the introduction of a ‘price floor’ to the market: say $20-22. With a price floor, traded prices couldn’t fall below that level. If they did, the price floor would kick in. This creates greater price certainty, and anchors expectations on the downside.

A second proposed reform, which would achieve the same goal through a different administrative method, would to allow market managers to withdraw permits from the market when prices weaken.This would create scarcity that drives up prices.

Similarly, to avoid prices spiking too high, market managers could add permits to the market. The aim is toensure a steady upward price climb to increase investor confidence and certainty.

The good news here is two fold.

First, problems like the above show that the EU ETS is maturing, and problems are being solved. This enables newer markets, like those evolving in China, to avoid making these same mistakes.

This should be the work of the interim period before the next big United Nations Framework Convention on Climate Change meeting in 2020. Already, organizers of next year’s talks are talking along these lines.

The second needed action point is greater commitment by individual countries to reduce domestic carbon emissions. This is being done through the system known as Intended Nationally Determined Commitments (INDCS). This was set up because countries couldn’t agree in 2009 on binding cuts.

The system relies upon peer pressure to get carbon emissions down. Surprisingly, the system seems to be working quite well. The good news is that countries are publishing their targets, ad most are taking it seriously.

The bad news is that commitments made thus far aren’t enough. But they are a start. Hopefully, additional commitments might be made later.

Bigger national commitments are needed to keep temperatures below 2c. Current commitments put the world on track to see temperatures of 3-3.5C higher by 2050.

A second, more flexible but more complicated reform would be to allow market administrators to withdraw permits from the market when prices get weak. This in turn creates scarcity and drives prices back up.

Managing the ‘supply’ of permits is a more flexible, but also more complicated, market management mechanism. In any event, one of these two markets reforms is certain to be implemented in 2020 to drive EU carbon prices higher.

The third big need is to fix the system know as the Clean Development Mechanism (CDM).Of the three policy initiatives (carbon markets, INDCs and ‘carbon offsets’ — as the CDM is often known) this one looks the toughest.

The aim was a good one. Under the concept, countries with high levels of emissions could — instead of reducing their own emissions — could invest in emission reductions in developing countries.

In theory, the concept was sound. It would spur investment in developing countries, raising their living standards while reducing global carbon emissions at a lower cost than doing so in more developed countries.

In theory, everyone would gain. In practice, however, the CDM has proven a mess of waste, fraud and abuse. At worst, it has provided cover for ‘fake reductions’ in carbon emissions.

The extend of the failure can be seen in the low traded prices of CERs — or receipts for such investments. Some of these go for less than $1, and the UN has even launched a ‘cancellation’ register to pull some of these disastrous instruments off the market.

Taken altogether, fixing the problems of pricing carbon and changing investment flows is proceeding well — albeit by fits and starts. This will result in increasing billions of dollars recycled into new energy generation and transmission technology creating a virtuous circle.

The upshot of this is the world looks to be on its way to muddling through fixing the looming problem of climate change through market measures.